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With the Potential Higher Capital Gains Rate Looming Interest in Opportunity Zone Funds Renews
Article Highlights:
- Potential Tax Changes
- Capital Gains Rates
- Qualified Opportunity Fund
- Deferred Capital Gains
- Tax Benefits
- Investment Care
One of the proposals included in the Green Book is to increase the long-term capital gain rates which currently, as illustrated in the table below, range from zero to 20%. Long term means the investment was held for a minimum of a year and a day.
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CG TAX RATES BY AGI RANGE FOR 2021
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| Filing Status | Zero Rate | 15% Rate | 20% Rate |
| Single | 0 - $40,400 | $40,401 – $445,850 | $445,851 and above |
| Head of Household | 0 - $54,100 | $54,101 – $473,750 | $473,751 and above |
| Married Filing Joint | 0 - $80,800 | $80,801 – $501,600 | $501,601 and above |
| Married Filing Separate | 0 - $40,400 | $40,401 – $250,800 | $250,801 and above |
The proposals would increase the tax rate for long-term capital gains to 39.6% (the proposed increase to the top individual rate is also included as one of the Green Book proposals) to the extent the taxpayer’s AGI (adjusted gross income) exceeds $1 million. That will result in a tax as high of 43.4% when including the 3.8% net investment income tax imposed on investment income of middle- to higher-income taxpayers. The proposal even suggests a retroactive rate change to be effective for gains and income recognized after April 28, 2021.
Example: Under the proposal, a taxpayer with $900,000 of wage income and $200,000 of long-term capital gain income would have $100,000 of capital gain income taxed at the current preferential tax rates shown in the table and $100,000 (which exceeds the $1 million threshold for the higher rates) taxed at ordinary income tax rates.
Qualified Opportunity Fund (QOF) - A tax tool at the disposal of taxpayers are investments in Qualified Opportunity Funds that can defer any long-term capital gain for several years.
Here is how it works: Taxpayers who have a capital gain from selling or exchanging any non-QOF property to an unrelated party may elect to defer that gain if it is reinvested in a QOF within 180 days of the sale or exchange. A taxpayer can reinvest less than the full amount of the gain in a QOF, and the remainder is taxable in the sale year, as usual.
A real benefit is only the gain need be reinvested in a QOF, not the entire proceeds from the sale. This is in sharp contrast to a 1031 real estate exchange where the entire proceeds must be reinvested to defer the gain.
The gain amount is deferred until the date when the QOF investment is sold or December 31, 2026, whichever is earlier. At that time, the taxpayer includes the lesser of the following amounts as taxable income:
a. The deferred gain or
b. The fair market value of the investment, as determined at the end of the deferral period, reduced by the taxpayer’s basis in the property. Initially, the basis is zero when the only investment in the QOF is the capital gain that is being deferred.
b. The fair market value of the investment, as determined at the end of the deferral period, reduced by the taxpayer’s basis in the property. Initially, the basis is zero when the only investment in the QOF is the capital gain that is being deferred.
Additional QOF Benefits – Besides providing the ability to defer the gain, QOFs also provide these additional benefits:
- For those that invest in a QOF before January 1, 2022, and hold it for 5 years the basis in the QOF is increased by 10% of the deferred gain. Thus 10% of the deferred gain ultimately avoids taxation.
- Where a QOF investment is held for 10 years or longer before selling it any gain (appreciation) attributable to the QOF can be excluded and only the deferred gain will be taxable.
Example: Phil sold a rental apartment building September 30, 2021, for $3 million, which resulted in a capital gain of $1 million. He invests the $1 million within the statutory 180-day window into a QOF and elects the temporary gain deferral exclusion. On October 1, 2026, Phil sells his interest in the QOF for $1.5 million.
Since Phil had held the investment over five years, his basis is enhanced by $100,000 (10% of $1 million deferred). Since the QOF included in the example had done well and appreciated to $1.5 million, the long-term capital gain reported by Phil would be:
Sales Price $1,500,000 Basis Enhancement (10% of $1 million deferred) - 100,000 Reportable 2026 Capital Gain $1,400,000
Had Phil not sold the QOF until 2032, and if the value of the QOF as of 12/31/2026 was greater than his deferred gain, he would have paid tax on the entire $1 million of deferred gain when he filed his 2026 tax return. His basis is then $1,000,000. When he sells the QOF in 2032 for the fair market value of $2,000,000, having held the QOF investment for 11 years (more than the 10 years required to make the FMV election), Phil can elect to treat the fair market value as his basis, and will have no taxable income ($2,000,000 sales price - $2,000,000 basis). Thus, he was able to defer for over 5 years paying tax on the original gain from selling the apartment and pays no tax on the $500,000 appreciation of the investment in the QOF.
However, if Phil had sold his QOF before holding it for 10 years, he would not have been able to exclude all the appreciation.
There is no tax law lower limit on the amount that must be invested in a QOF, so they are available to taxpayers of any means.
Not all states conform to the gain deferral and basis adjustments provided by QOFs.
Please contact this office if you have questions related to how your tax situation would be impacted by investing in a QOF.
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